Tuesday, 31 January 2012

A trillion euros is not enough

European leaders are again meeting to devise yet another Eurozone rescue plan. They met in December for the same reason. The summits have now developed a tedious repetitive quality. They start with flashy photo opportunities, as the leaders arrive in Brussels. There are two days of late-night discussions, and cosy dinners. The summits conclude with a multilingual press release promising decisive action to finally resolve Europe's financial crisis. And then, nothing..... A month later, EU leaders are back again in Brussels running through the same tired routine.

To get some idea of the magnitude of the crisis facing the Eurozone leadership, look no further than at the recent policy decisions of the European Central bank. Before Christmas, Europe's central bank created an emergency funding scheme for the continent's banks.

One interpretation of this emergency fund is that it is an indirect mechanism for supporting weak banks. The European Central bank is charging an interest rate of only 0.5 percent on loans with maturities of three years. In other words, the ECB is for all practical purposes offering free money to the banks. In theory, banks can then lend the money at a higher interest rate and pocket the difference. This huge margin should, in principle, making European banking highly profitable and overtime, these profits should strengthen the financial position of Europe's banking system.

The ECB also had an eye on upcoming bank bond repayments. The fund was to avert a potential credit crunch, as banks had to roll over huge redemptions and interest payments that were due during the first quarter of this year.

However, it has become painfully evident that he liquidity difficulties of European banks were worse than anyone feared. Almost immediately, banks demanded €489 billion of emergency funding. Today, the financial Times reports that European banks may now require upwards of €1 trillion of emergency support. That is a staggeringly large figure. The huge demand for liquidity has confirmed what many had suspected. The balance sheets of Eurozone banks are deeply compromised.

This emergency lending facility wasn't just about handing out massive amounts of free money to wobbly banks. The ECB had an ultimate target for all this cheap liquidity. It was a European sovereign debt markets. European banks, flush with free money, were supposed to buy large quantities of Italian, Greek, and Portuguese debt.

So far, it hasn't worked out that way. Some Portuguese bonds have interest rates as high as 17 percent. The Greeks are likely to default within weeks. Italian interest rates also remain dangerously high. So far, the great ECB liquidity tsunami has failed to stem the Eurozone debt crisis.

Rather than investing in Eurozone governments, European banks are holding onto the cash. Fear has gripped the Eurozone economy. That fear has a name - default. The continent is overloaded with debt and the banks fear that debtors will be unable to repay their loans.

Europe is now waking up to an unpalatable reality; sooner or later all debts must be repaid by someone. If the ECB prints money, and inflation takes hold, the real value of debt will fall, and creditors will suffer a loss in purchasing power. In terms of goods, their investments will buy less. Inflation is a de facto default. If ECB prints money, and banks hoard that cash, then debtors will have to find real resources to pay off their debts. If debtors can't find the resources, which seems to be a case for the Greek government, they will have to default. Either way, someone has to repay the debts.

There is no inflationary road out of this mess. A trillion euros of free ECB money is not enough to save the Eurozone.

"sooner or later all debts must be repaid.... If the ECB prints money, and inflation takes hold, the real value of debt will fall, and creditors will suffer a loss in purchasing power.... Inflation is a de facto default.